Saturday, May 28, 2011

I have read the accounts of several dozen Chinese reverse takeover stocks and many traditional IPOs, mostly looking for fraud but also looking for stocks to go long to offset my naturally large short position. And I am annoyed. China Fire and Security (CFSG:Nasdaq) was on my list to look at but I never got around to it.

So I took the recent news of a "definitive agreement" to buy CFSG by Bain (a large and reputable private equity shop) very badly. After all it was a profit opportunity wasted because I never got around to reading the accounts.

And it is a deal with quality advisors too. According to the press release:

Barclays Capital is serving as the exclusive financial advisor to the Special Committee [that is CFSG on behalf of non management shareholders]. Shearman & Sterling LLP is serving as U.S. legal advisor to the Special Committee and Bilzin Sumberg Baena Price & Axelrod LLP is serving as Florida legal advisor to the Special Committee. Bank of America Merrill Lynch, The Hongkong and Shanghai Banking Corporation Limited and Citigroup Global Markets Asia Limited are serving (themselves or through their affiliates) as financial advisors to Bain Capital as well as underwriters, bookrunners and mandated lead arrangers of the debt facilities. Kirkland & Ellis International LLP is serving as U.S. and U.K. legal advisor to Bain Capital. Davis Polk & Wardwell LLP is serving as U.S. legal advisor to Barclays Capital. Allen & Overy is serving as U.S. and U.K. legal advisor to the underwriters, bookrunners and mandated lead arrangers. DLA Piper and Han Kun Law Offices are serving as international and PRC counsel to Mr. Weigang Li [the Chairman of CFSG].

This is by far the best team of big name lawyers and advisers ever assembled to do a deal with a sub-$300 million market cap reverse takeover Chinese stock. There must be quality here to assemble such a big name team. And I want to be able to pick these transactions in advance so I went looking for the quality. I read the 10K cover to cover (all 87 pages) just to see what they saw. After all Bain are clever people and the advisors assembled are not stupid.

What I found was a strange company – one that I did not understand – in fact one that made me think I don't understand very much at all. The clever people at Bain want to buy this company with a value of almost $300 million – and – for the life of me I could not have picked it.

Lets start at the beginning...

My run through the 10K

Here is the business description:

We are engaged primarily in the design, development, manufacture and sale of a variety of fire safety products for the industrial and special purpose infrastructure industries and the design and installation of industrial fire safety systems in which we primarily use our own fire safety products. To a minor extent, we provide maintenance services on our industrial fire safety systems for our customers. Our business is primarily in China, where we operate sales and liaison offices in more than 20 cities; we are also expanding our business overseas by providing integrated fire safety systems to industrial clients globally.

We market our industrial fire safety products and systems primarily to major companies in the iron and steel, traditional power generation, nuclear power generation and petrochemical industries in China. In the last two years, we also secured several contracts with power generation plants in India. We are further developing our business in the transportation sector, which includes projects involving subways, highway tunnels, high speed trains and marine transportation, and telecommunications.

We have internal research and development facilities engaged primarily in furthering fire safety technologies. We believe that our technologies allow us to offer cost-effective and high-quality fire safety products and systems. We have developed products for industrial fire detecting and extinguishing. We believe that we are the leading manufacturer in China of such systems having successfully developed a comprehensive line of linear heat detectors.

In other words they are a manufacturer and installer of fire detection and extinguishing kit. The kit they install is primarily the kit they manufacture. There is a small maintenance sideline.

The products did not sound very technical. Water mist extinguishers are just devices (usually pressurized cannisters) that spray out a water mist for putting out Class A fires. You can find lots of suppliers on Alibaba.

Linear heat detectors were a little newer to me. They are wires that can detect raised heat anywhere along their length - usually two wires with a heat-sensitive polymer core. Here is an example - and you can find many of them (with their control boxes) on Alibaba.

Bluntly then - at the core of this business is a manufacturer. I was thus expecting a balance sheet and profit and loss account typical of a manufacturer. A manufacturing business is usually concerned with managing working capital (inventory turns, work in progress, billings), has a fair bit of plant and equipment and margins which are typically high single digit percentage, though higher if the level of R&D is high or lots of capital is employed in the manufacturing process. Fatter margins come from market structure (monopolies or government protection) or lots of capital employed (which has to be recovered) or from being innovative (and keeping competition out by know-how advantages).

Alas the accounts are nothing like that. The balance sheet left me gob-smacked: I have puzzled and puzzled over this.

Here are the current assets (for reference you should compare this to total revenue of just shy of $80 million):

CURRENT ASSETS:

Cash and cash equivalents

$

28,151,689

$

34,976,880

Restricted cash

1,935,979

1,837,134

Notes receivable

14,428,802

4,274,268

Accounts receivable, net of allowance for doubtful accounts of $8,153,727 and

$6,539,787 as of December 31, 2010 and 2009, respectively

41,895,129

30,989,569

Receivables from and prepayments to related parties

2,448,066

551,792

Other receivables

792,386

368,679

Refundable bidding and system contracting project deposits

1,667,437

1,774,330

Inventories

6,713,448

5,360,520

Costs and estimated earnings in excess of billings

40,660,013

36,562,573

Employee advances

1,114,080

953,625

Prepayments and deferred expenses

10,281,292

3,397,358

Total current assets

150,088,321

121,046,728

This is amazing. The company has $41.9 million in accounts receivable: over 6 months of revenue employed in working just there. Then it has $40.7 million in costs in excess of billing. Another 6 months revenue employed there. And another $10.3 million in prepayments and deferred expenses, $1.1 million in employee advances, $1.7 million bidding deposits, and a relatively trivial $6.7 million in inventories. The company has deployed over 100 million dollars in working capital on behalf of their customers and they count all that as current assets. This company looks like it is in the business of financing their customers.

Three are also 14.4 million in notes receivable and that looks like explicit customer financing.

I am an accounting geek - and I can't resist an accounting geek's aside here. Current assets are - by definition - assets that the company can reasonably expect to turn to cash within a year. (If they take longer to turn to cash they are not current.) This company has more than a year's revenue locked up in working capital. Can someone explain to me how it is possible to consistently have more than a year's revenue locked up in working assets and have them all counted as "current"?

So the company is thin on inventory but very strong on financing their customers through receivables and through costs in excess of billings and even through notes receivable.

They are however very thin on actual plant and equipment. Here is the plant and equipment line:

PLANT AND EQUIPMENT, net

9,641,119

8,617,521

They have 9.6 million dollars of plant and equipment - less than 10 percent of their working capital provision. If you look at the balance sheet this is not a manufacturing company (there are very few actual manufacturing assets). This is a finance company financing its customers (conventional and nuclear power stations, petrochemical plants, railways etc) through working without billing and by being slow to collect. They also explicitly provide finance through notes.

Very strange. Especially as the customers almost certainly have better access to funding that what is really just a little fire-and-security company.

Fortunately for us the plant and equipment line is further broken down in the 10K.

December 31,

2010

December 31,

2009

Buildings and improvements

$

7,258,465

$

6,439,015

Transportation equipment

3,963,302

3,307,236

Machinery

901,655

900,781

Office equipment

1,083,512

1,348,261

Furniture

126,032

165,736

Total depreciable assets

13,332,966

12,161,029

Less accumulated depreciation

(3,988,332

)

(3,875,487

)

Construction in progress

296,485

331,979

Plant and equipment, net

$

9,641,119

$

8,617,521

Now I am really puzzled. Before depreciation they only have 900 thousand dollars of machinery.

They have three times more "transportation equipment" (trucks and cars) than machinery. They even have more "office equipment" (computers, desks) than machinery.

This is a very peculiar manufacturer indeed. It operates almost without machinery. I assure you 900 thousand dollars - pre-depreciation - does not buy you very much manufacturing kit - even in China. (If you do not believe me start looking up prices for things like wire-drawing equipment equipment on Alibaba.)

Come to think of it - there is not much in in these accounts for buildings either: $7.5 million before depreciation. Even in China that buys a single large building. It hardly buys a campus.

Whilst the company is extremely willing to finance its customers (by extending credit through large receivables or by work in excess of billing) it does not draw much funding from their suppliers.

CURRENT LIABILITIES:

Accounts payable

$

7,666,967

$

6,903,961

Accounts payable to related party

-

272,994

Customer deposits

3,023,329

2,182,790

Billings in excess of costs and estimated earnings

2,872,706

1,429,999

Other payables

838,413

333,121

Accrued liabilities

19,737,906

13,841,300

Taxes payable

9,416,829

9,002,470

Total current liabilities

43,556,150

33,966,635

The main thing to note here is that the "working capital liabilities" are much smaller than the "working capital assets". They only have 7.7 million in accounts payable for instance versus over 40 million in accounts receivable.

There is no debt - but there are 19.7 million in accrued liabilities - all subcontractor expenses.

Summary thus far

This is a really strange company: its a manufacturing company whose balance sheet contains next to no manufacturing equipment but vast extensions of credit to the customers. It is certainly not the business described in the "business description" part of the accounts.

Margins and the P&L

The P&L shows a fat margin business - albeit one with declining profitability:

2010

2009

2008

REVENUES

System contracting projects

$

59,544,090

$

62,514,475

$

57,101,984

Products

16,834,582

15,718,815

9,673,922

Maintenance services

3,598,010

2,947,908

2,303,213

Total revenues

79,976,682

81,181,198

69,079,119

COST OF REVENUES

System contracting projects

28,897,445

26,769,508

25,805,086

Products

7,342,962

5,589,310

2,558,844

Maintenance services

2,457,833

1,769,104

1,217,316

Total cost of revenues

38,698,240

34,127,922

29,581,246

GROSS PROFIT

41,278,442

47,053,276

39,497,873

OPERATING EXPENSES

Selling and marketing

10,135,884

8,908,697

6,434,887

General and administrative

10,822,596

8,154,801

6,680,992

Depreciation and amortization

851,036

773,907

712,269

Research and development

1,966,557

1,631,435

2,102,976

Total operating expenses

23,776,073

19,468,840

15,931,124

INCOME FROM OPERATIONS

17,502,369

27,584,436

23,566,749

Gross margins are over 50 percent of sales. Net margins (even in the relatively poor 2010 year) were 17.5 million/80.0 million or almost 22 percent.

I like to break this margin down into the two things the company does. The company seemingly provides credit to all its customers (I think we demonstrated that above), and it does manufacturing and installation.

It provides roughly 15-18 months credit to its customers (look at the working capital provision). It should make about 7 percent margin on that (just reconfigure as a loan). The rest of the business makes about a 15 percent operating margin. That is down sharply from prior years - but is still a quite nice manufacturing margin.

It is a staggering manufacturing margin for a business which has almost no capital employed in manufacturing equipment. All that margin on only $900 thousand of machinery in a manufacturing business is really strange.

So what manufacturing equipment do you get for $900 thousand?

The key to this is working this out is going to be what sort of equipment they use and whether they really do anything special on it (deserving fat margins) - and how on earth do you run a large manufacturing company with only $900 thousand of machinery.

So I went looking at their website for pictures of the plant and machinery and (thankfully) the company obliged. Here is a sampling. Alas some of the pictures are very low resolution. I did not take them: they came from the company's website.

The caption on the above photo is "Production Line of automatic fire protection electronic products".

The captions on these are "Full-scale fire Test Center" (both above ground and underground section).

This photo was captioned "The photoelectron workshop".

And here is their Design Center though the eagle-eyed will notice that it is also the fire-test center photographed above:

The whole campus is shown on their web-page with the main manufacturing subsidiary (Sureland) in the background and the two main other buildings in the foreground. There is a little wide-angle to exaggerate the size of the campus - but there are still three substantial buildings plus the underground testing center. These are not the only buildings the company uses.

These are a pretty impressive set of buildings. It is surprising that they can be purchased for $7.7 million (pre-depreciation) as per the accounts. I thought they might be leased but the words rent or lease do not appear anywhere in the annual accounts (except where they lease a house for one of their executives). So we can presume these buildings are owned.

A fire testing facility (especially an underground one) would have some equipment in it - but probably not much as it gets burnt every now and again (which is presumably what "testing" is about).

I have absolutely no idea what they do in a large "photoelectron workshop" but I figure it must be full of equipment.

Whatever - there is a lot of building here for $7.7 million and (presumably) a very large amount of equipment filling those buildings (with a cost of only $900 thousand).

I presume Bain and the other people backing this takeover are perfectly happy with the audit they received. I presume they have done their own due diligence - after all the auditor is Frazer Frost. Frazer Frost is (to my knowledge) the only American audit firm thus far sanctioned by the SEC over China frauds. (Eagle-eyed observers will notice that the firm sanctioned by the SEC is named Moore, Stephens, Wurth, Frazer & Torbett. The firm has been through a few name changes and restructures.)

Still - Bain are taking this company private. I hope they have double-checked the obvious audit problems. The most obvious problem is determining whether the current assets (most notably receivables and work done but not billed) are real. Bain are competent people - I presume they have done that.

As I said repeatedly, I do not understand these accounts, but I have only spent a day looking over them. Lots of prestigious organizations and people are involved in this deal. They must all be cleverer than a two-bit hedge-fund manager sitting at a desk near the beach in Australia. Even if individually they are not as clever as me they must collectively be cleverer than me. Here is a partial list of people working on this deal:

That is a pretty remarkable lot. Whilst I usually dislike appeals to authority I have to cede to such an overwhelming collection of intellect.

So what does Bain see in the deal?

Once you work through all this - and you accept the accounts as the gospel truth - you realize that Bain has a true bargain.

This is possibly the most efficient purchaser/constructor of buildings in China if not the world. They purchased all those buildings for $7.7 million.

They are without question the most efficient purchaser or constructor of machinery in the world. They equipped this entire company with machines for $900 thousand before depreciation.

They also have a huge and presumably easy to collect lot of current assets outstanding. There is $150 million in current assets here - and they should - with better management - be able to turn $100 million into cash without impacting the business. After all, the customers are solvent parties that do not need all that credit extended to them. $100 million additional cash plus the $28 million cash on the balance sheet will offset more than a third of the purchase price for the business. It should pay off the bulk of the bank debt so Bank of America should be fine.

This deal is a work of genius. Unfortunately as a stockholder I will not be around to enjoy it. CFSG is going private.

22 comments:

Good writeup. My experience is that many of foreign firms are so desperate in doing deals in China that they have basically put the blinders on and let their local staff do whatever it takes to get deal flow. These deals would have never passed the smell test with the investment committee had it been an US deal.

Do you think there is any way this can be some type of fraud/scam with a fake buyout offer? I don't see how it can be, because we have all these big name firms that signed onto the deal - and I'm sure that these guys don't come cheap. And I don't know the play that management can make if they want to steal U.S. investor money. Maybe they are going to dump insider's shares while the price is inflated by merger arbs? Can they really do that? Most shares of these MBO Chinese RTOs are restricted, unlisted shares that they need to register first.

If these MBO offers are real, regardless of the fundamentals of the company, then should we be merger arbitraging? CSR (who also have some big name banks and lawyers involved in their MBO) and CFSG have a pretty good spread to the buyout price. I know there are a few US Chinese listed names that went through a MBO successfully and those merger arbs did okay. It's a very confusing space to play.

"They also have a huge and presumably easy to collect lot of current assets outstanding. There is $150 million in current assets here - and they should - with better management - be able to turn $100 million into cash without impacting the business. After all, the customers are solvent parties that do not need all that credit extended to them. $100 million additional cash plus the $28 million cash on the balance sheet will offset more than a third of the purchase price for the business."

This sort of leads to the obvious (to me) question: why would a company that is this profitable go private at a low valuation?

As a side note, reading your blog has been a hell of a lot more useful than going through the coursework for an MBA designation. I wish there was a way to thank you for all this.

I think they must do everything by hand utilizing cheap Chinese labor, hence the absence of machinery or other fixed assets (other than the amount noted for the chairman's car). How can you question a company where the second largest shareholder is an entity called Chinese "Honor" Investment Ltd (emphasis added)?

Absolutely hilarious stuff. I wonder how many people will miss the tone?

In a previous life, I used to work at an FDA-inspected health supplement manufacturer. We probably blew 900K just on the QC equipment. Mind you, our gross revenue was only $50M, so obviously our operations weren't as top-notch as CSFG's are.

Remember that advisors, auditors, bankers, lawyers, have no real liability should a deal turn out bad. Their interest is in collecting fees and only fees. They have no interest in protecting outside investors.

Relying on the argument from authority is what the con men want you to do. It is how the con works.

Having been through a few Bain diligence reports which always find a way to back up the geniuses that commissioned them I understand that there is no negative too negative to have an ingenius MITIGANT! Bravo Bain you clever boy(boy said with an irish accent here like "bye")

I was involved in the sale of a similar company in the US. I think in reality once you dig through all the hype this is really a fire sprinkler company -- or perhaps a slightly upmarket version of that. The physical plant numbers could be off, I don't know, but it's not a very capital intensive business in terms of physical plant. Anyway this US company I refer to had absurd levels of AR. Basically they are financing the contractors installing the equipment who are always in desperate need of capital due to hold backs and razor thin margins. The company's competitive advantage was that they provided good financing terms and the billing practice was to charge more for the goods to firms known to pay later.

Anyway this company with rather limited growth prospects due to the mature nature of the industry still sold for 8x ebitda.

let me tell you why Bain did this deal. Feeling the need to established a presence in China, many PE firms have established branches in China. Bain Cap is one of them, but there are others.

However, the people they recruit are of sub-par caliber. The requirements for working in PE in China is (a) Knows both Chinese (verbal and written) and English and (b) has finance and/or consulting experience.

But what happens is that the truly smart candidates, those who speak and write both Chinese and English fluently, are also smart enough to find a PE job in the US. So what you end up are subpar candidates working at the Chinese branches. They may have an impressive resume on paper, but once you interacted with them, you know they are not the sharpest knifes in the drawer (though they could be very book-smart).

So now you have a below par team in place, partners in the US are especially successful in raising money and want to put it in use so that they can start collecting the management fee. So they tell their Chinese arms "Find me deals to do". And what you have here is the result of that. Sub-par talent forced to find LBO deals in order to collect the management fee for the US partners.

Another red flag. Their allowance for doubtful accounts is 8 million out of 50 million gross receivables (42 million net receivables). 16% of receivables have been written off? You'd expect them to do a better job with credit checks on their customers. Otherwise they'll need massive margins on the sales to cover the continued credit write-offs (like a rent-to-buy company serving high credit risk customers). This could explain why net margins are so high on a simple product. Doesn't sound like a good business model which Bain would be interested.

Could you explain one thing? I assumed most Chinese stock frauds are vehicles to allow management/main shareholders to sell inflated shares to the ignorant public. Setting aside Bain is not your typical ignorant investor, the management are also not cashing out as mentioned in the press release (see below). This is a management led buyout. If the company is a fraud like some of the other's you've uncovered, it would blow up shortly without giving management the time to cash out.

"Under the terms of the merger agreement, each share of the Company's common stock issued ... will be cancelled in exchange for the right to receive $9.00 in cash, except for (i) ... shares ... related to Mr. Weigang Li, the Chairman of the Board, Mr. Brian Lin, the Chief Executive Officer of the Company, and Mr. Weishe Zhang, the Vice President of Strategic Planning of the Company, which will be cancelled without receiving any consideration."

Finally, I wouldn't take too much comfort from the impressive names listed as advisors. The law firms will happily crank through the documents and receive fees. There is very little downside for them if this blows up. The only firms at risk are Bain's investment banks and underwriters of the debt. If it is a bad deal, they get stuck with the credit losses and maybe get sued by Bain in the same way Guy Hands sued his banks over the EMI deal (which he lost). Therefore, BofAML, Citi and HSBC better due their due diligence on this one.

You also should be pretty skeptical of the law firms - while some have high-quality partners with real local expertise and business savvy, in many cases US/UK firms and their aging baby boomer partners are DYING to rebrand themselves as Asia experts to avoid becoming dinosaurs and getting pushed out by younger, hungrier people. So they assemble a team of FOB Asian associates who look the part but know no more about Chinese business than I do and white kids who went to Yale but have never had any job outside of the academy before. These are not the most critical or independent business thinkers. With minimal supervision from the partner, this crack team performs "due diligence" that mostly consists of making sure that the target company has many pieces of paper and someone who can answer questions without appearing to be lying. While Chinese companies have lagged in this area, at this stage I think their paper-generating and bull-shitting abilities are coming much closer to that of large US companies. The lawyers are not on site, they don't know anything about how fraud is conducted, they may not know much about China, and they are not really looking for problems (everyone just wants to close the deal).

"We market our industrial fire safety products and systems primarily to major companies in the iron and steel, traditional power generation, nuclear power generation and petrochemical industries in China."

vs.

"This company looks like it is in the business of financing their customers."

John, if you're going to keep after these China plays, you need to spend a few years running a Chinese SME selling to large SOEs to learn how to read the books.

By Western accounting standards, that $100m in vendor financing should probably be on the books as "goodwill". That is, it represents an investment in a favorable market access position which can reasonably be expected to produce excess returns.

They've bought their way into a gravy train.

Consider for a moment the switching costs of swapping out the fire control systems (or even, for that matter, the fire control systems vendor) at a nuclear power plant.

Aren't you basically saying that the accounts are unreadable if interpreted according to western standards? That $100M (!) receivables isn't that, it's some other type of nebulous long-term investment?

That's all very well, except then why are they then listing themselves on a U.S. exchange? Claiming U.S. auditors? Where's the footnote saying "these numbers don't mean at all what they think you mean, but in our culture they are nevertheless impressive?" Doesn't Occam's razor point towards them being fraudulent no matter what accounting culture you are from?

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.